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In August 2007 HUD began allowing borrowers to get FHA adjustable loans based on the LIBOR index.

Given the events of the past week a lot of FHA borrowers with LIBOR indexes may wonder about their choice. As Canada’s Financial Post reported last Tuesday “the London Interbank Offered Rate, or LIBOR, which is set by 16 banks, rose the most ever, jumping 431 basis points.”

Translation: The rate for overnight loans among banks rose 4.31 percent in a day to 6.88 percent. That’s right — the rate more than doubled.

The reason for HUD to use the LIBOR was that it would make mortgage-backed securities easier to sell to overseas investors who prefer the Euro to the dollar. The reason for borrowers to use the LIBOR is, well, er, whatever….

As well, it was said, the LIBOR and the one-year Constant Maturity Treasury (CMT) index tended to follow the similar pricing trends. As we mentioned when the LIBOR option was introduced, the LIBOR index typically has a 2.25 to 2.50 margin while an ARM with a Treasury index might have a 2.75 percent margin.

There is, of course, no guarantee insuring how the LIBOR or any index might move.

The overnight increase in the LIBOR does not necessarily mean that other LIBOR indexes will quickly rise. For instance, the 1-year LIBOR was at 3.20688% for September.

However — and this is hugely important — even if an index goes up rapidly, FHA mortgage borrowers have considerable protection because they have the advantage of sane program limits.

“The interest rate cap structure provides some protection from large interest rate swings. There are two types of caps: (1) annual, and (2) life-of-the-loan. The annual cap restricts the amount your interest rate can change, up or down, in any given year, while the life-of-the-loan cap limits the maximum (and minimum) interest rate you can pay for as long as you have the mortgage. FHA offers a standard 1-year ARM and four “hybrid” ARM products. Hybrid ARMs offer an initial interest rate that is constant for the first 3-, 5-, 7-, or 10 years. After the initial period, the interest rate will adjust annually. Below are the different interest rate cap structures for the various ARM products:

“1-year ARM and 3-year hybrid ARM have annual caps of one percentage point, and life-of-the-loan caps of five percentage points. (Example – if your initial interest rate were 5.00%, the highest possible interest rate would be 10.00%)

“5-, 7-, and 10-year hybrid ARM have annual caps of two percentage points, and life-of-the-loan caps of six percentage points.”

The bottom line: While index levels can rise, FHA borrowers benefit from interest-rate caps. No less important, unlike most private-sector ARMs the FHA program bars negative amortization. That means your principal balance can never increase — and that should be comforting.

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